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Streetwise

The Houdini Market

By

Ben Levisohn

October 19, 2013

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Harry Houdini was famous for his escapes—from handcuffs, straitjackets, oversized milk cans, and a water-filled box known as the Water Torture Cell. This bull market might soon be famous for escapes of its own.

Consider: Since the rally began, in March 2009, there has been the flash crash, the Greek default drama, the U.S. debt-ceiling debacle, the Standard & Poor's credit-rating downgrade of the U.S., the sequester, and the great taper scare. Each of these, we were told, could have ushered in a new bear market. Instead, the S&P 500 squirmed out of the traps and headed higher. And for its latest trick, the market had to avoid the double whammy of a government shutdown and a potential default.

Some investors doubted the market's ability to wriggle free. They pulled $5.2 billion out of U.S. equity funds in the week ending on Oct. 9, according to the Investment Company Institute; the amount was more than the withdrawal in any single month this year. Mutual-fund managers, for their part, made defensive moves such as holding more cash and adding less-risky holdings, to an extent that suggested they expected a replay of 2011's debt-ceiling-induced 17% drop, according to JPMorgan.

Last Wednesday, however, Republicans and Democrats agreed on a deal to reopen the government and raise the debt ceiling, and the stock market surged higher. By the end of the showdown, the S&P 500 had gained 2.4% and finished last week at a new all-time high of 1,744.5, despite high-profile earnings misses from companies such as
Goldman Sachs
(ticker: GS),
International Business Machines
(IBM), and
UnitedHealth
(UNH). The S&P 500 is now up nearly 160% since its 2009 low.

"Bull markets have a certain momentum to them and can brush off inconvenient things," says Richard Sylla, a financial historian at New York University.

Still, many market observers are already casting a wary eye on the road ahead. They point to damage to U.S. economic growth, which will take a hit from the shutdown. They fear a repeat of chaos in Washington, a not-unrealistic concern considering the fact that the deal signed by President Barack Obama provides only a short-term fix.

Yet, even a repeat of the recent shutdown might not be as bad as some investors fear. Of the 17 previous shutdowns, four started less than nine months after the previous one. In those instances, the S&P 500 lost just 0.4% and gained 2.3% during the 10 days after the government was reopened, according to data from Ned Davis Research.

That isn't to downplay the danger inherent in these crises. The International Monetary Fund warned of dire consequences for the global economy if the debt ceiling was not raised, while China and Japan both told the U.S. to get its act together. If a deal hadn't been reached, and the U.S. had in fact defaulted, the stock market could have lost a lot more than it did back in 2011. "It's a pretty binary event," says Thomas Lee, chief U.S. equity strategist at JPMorgan, who expects the S&P 500 to finish the year at 1,775. "We just had to make sure we didn't default."

Does this mean there's no escape too tough for the stock market? Hardly. A new set of snares awaits has we head into the new year. For starters, 2014 will be the second year of a presidential cycle, typically a tough one for stocks. And of course, there's still tapering to contend with. Due to the damage inflicted by the shutdown, many investors now expect the Fed to start tapering no earlier than January and perhaps as late as March. Even then, the Fed is expected to keep interest rates low for as long as possible. But if the U.S. economy picks up steam—and brings with it a sudden rise in prices—the Fed could be forced to act more quickly than anyone, itself included, expects. Such a scenario was responsible for a 5% drop in the S&P 500 in the first half of 1994 and was a prime suspect in the Black Monday plunge of 1987. "The main danger for the equity market is the bond market falls apart and takes equities with it," says Michael Shaoul, CEO of Marketfield Asset Management.

Those are next year's concerns, however, and Shaoul says the S&P 500 has a chance to hit 1,800 before year end. For now, sit back and enjoy the show.

A DIFFERENT KIND OF ESCAPE took its toll on
Invesco
(IVZ) last week. That would be the departure of its star United Kingdom fund manager, Neil Woodford, who announced he was starting his own investment firm. That decision caused Invesco's stock to plunge 6.4% that day, as investors feared Woodford's assets would follow him out the door. According to Citigroup's William Katz, the drop assumes that 40% of the $50 billion Woodford now manages will depart—a number much closer to the 53% that fled TCW Total Return fund after Jeffrey Gundlach's departure than to the 4% that left Fidelity Magellan after Peter Lynch resigned. Katz believes the hit on Invesco is far too pessimistic. A "disorderly reaction to an orderly transition creates" a buying opportunity, he notes.

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